If you're considering a new job or negotiating your employment contract, you may come across the term "cliff vesting." But what does it mean, and how does it affect your equity compensation?
This guide aims to explain what you need to know about cliff vesting, whether you're an employee about to accept a new job offer or a startup founder who's issuing stock options to retain employees on your startup team.
Cliff vesting is a type of time-based vesting schedule used in employment contracts for equity compensations like stock options, restricted stock units, or performance shares. Under a cliff vesting schedule, an employee becomes fully vested in their shares or options after a specific period has elapsed.
Think of a cliff as the probation period which gives the company time to see how an employee performs, before they receive any equity. In the case of stock options, this means that an employee must remain with a company in order to start exercising.
Cliff vesting works by deferring an employee's entitlement to full benefits and equity compensation until they've completed a specific period of service, typically measured in years. During this period, the employee accrues equity rights that vest gradually over time, with a lump-sum payout at the end of the period.
This “cliff period” typically lasts between one and four years, depending on what's agreed upon by the employer and employee – but it can also be customized for individual employees or teams.
Once the cliff period is over, the employee (or founder) will start to vest their equity units on a predetermined schedule. This means that they can access their shares and any proceeds from the sale of those shares at regular intervals until the entire block of shares is fully vested.
Graded vesting and cliff vesting are two types of time-based vesting schedules. While both types of vesting schedules require an employee to remain with a company for a certain period of time in order to fully earn their equity compensation, they differ in how that specified period of of time is structured.
In graded vesting, equity compensation is earned gradually over time, rather than all at once. For example, an employee might be granted stock options that vest at a rate of 25% per year over four years. This means that after the first year, the employee has earned the right to exercise 25% of their stock options, and after the second year, they have earned the right to exercise 50%, and so on, until they have earned the right to exercise all of their stock options after four years.
In cliff vesting, equity compensation does not vest at all until a specific length of time has passed. For example, an employee might be granted restricted stock units that vest after a one year cliff. This means that the employee does not earn any ownership rights to the stock units until they have been with the company for one full year. At the end of the one year cliff, all of the stock units vest at once, and the employee has full ownership of them.
To illustrate better, here are some cliff vesting examples:
An employee is granted 5,000 stock options as part of a job offer. The cliff vesting schedule is 1-year cliff vesting plan – meaning the employee won't receive any equity until they have worked at the company for an entire year.
After one year of service, the employee can now exercise their 5,000 stock options and become a shareholder in the company.
Similarly, if the agreement states 3-year cliff vesting period, it means the employee will not have access to their stock options until 3 years of service have been completed. Only when the employee reaches the 3-year mark can they access the equity in one lump sum (in the case of stock units) or begin exercising his options (in the case of stock options).
Getting the drift? Let's keep going.
If the agreement states 4-year cliff vesting, then this means the employee can't access his equity until their 4-year mark at the company.
While this is a possible vesting agreement, it may not be the best vesting agreement if your goal is to attract today's young generation of talents. Studies show that millennials and gen-z workers have a tendency to job-hop and spend less than 3 years in a job. It's important to take factors like this into consideration when deciding vesting conditions for valuable employees at your startup.
With that said, the most common type of vesting condition is a combination of cliff vesting and graded vesting. Specifically, the 4-year vest, 1 year cliff.
4-year vesting with 1-year cliff is a common vesting conditions when it comes to employee stock option plans or equity agreements.
In this scenario, the vesting period has a duration of 4 years, which means that the employee's stock options will become fully vested after 4 years of service with the company. The "1-year cliff" refers to the initial period where the employee has to stay for a year before their stock options begin to the four year vesting period.
After the cliff period, vesting typically occurs on a pro-rata basis, meaning that a percentage of the equity would vest gradually over time.
In this example, if an employee was granted 1,000 stock options that are subject to 4-year vesting 1-year cliff, 25% of their shares would vest after the first year (250 shares). The remaining 75% would vest gradually over the next three years (250 shares each year).
If an employee leaves before this period ends, he walks away without anything and the unvested options would be returned to the option pool.
Here at Cake, we aim to empower founders to build amazing companies through equity across borders. We understand that equity compensation plans can be overwhelming for startup teams. Our goal is to provide the tools to remove the overwhelm.
Cake simplifies granting, vesting, and exercising equity grants – both for startup founders and employees.
Here are some of the yummy and not-so-yummy aspects of cliff vesting for you to appreciate:
If you leave the company before the cliff period ends, you'll forfeit your right to any unvested equity compensation. However, you'll still own any vested equity compensation.
Yes, cliff vesting schedules can vary in length, depending on the company's policies and the type of equity compensation being granted.
Cliff vesting differs from other types of vesting schedules, such as graded vesting, in that all equity compensation is vested at once, rather than gradually over time.
This article is designed and intended to provide general information in summary form on general topics. The material may not apply to all jurisdictions. The contents do not constitute legal, financial or tax advice. The contents is not intended to be a substitute for such advice and should not be relied upon as such. If you would like to chat with a lawyer, please get in touch and we can introduce you to one of our very friendly legal partners.